Why life firms will never deliver building society-style bonanzas
Insurance de-mutualisation is not quite what it seems.
Friday 07 February 1997
Members of mutual insurers are unlikely ever to see such large windfalls as the ones being handed out to their building society counterparts, who will receive up to pounds 20bn worth of shares this year as a result of conversions from mutual status to ordinary banks.
The headline number of Abbey National's offer for ScotAm is pounds 1.4bn. But policyholders have already discovered that they will not receive anything like as much. Their true cash windfall is no more than pounds 400m.
The explanation for the discrepancy between the value of these mutuals and the amount policyholders will be paid for giving up ownership lies in the complex regulations and actuarial and accounting procedures that govern them.
Indeed, some of the money in these offers is not new cash at all but may ultimately come from the policyholders themselves - in effect bringing forward payments of bonuses they would have received in the future.
Here we attempt to answer some of the questions that have arisen about the value of mutual insurers over the last few weeks.
Why are building societies worth so much more to their members than mutual insurers?
The basic reason is the difference in the way the two types of society have operated. Early building societies shared their profits with their members. But for many years, the majority have behaved just like conventional banks, setting market rates for mortgages and deposits, and making substantial annual profits.
With no dividends to pay to shareholders, building societies have built up enormous free reserves. These belong to the members and the value is distributed in cash or shares when a society converts.
Insurers have kept much closer to the ideals of mutuality. They have behaved very like the early building societies by distributing profits to members as they go along. They offer annual and terminal bonuses, which are basically a regular payment of profits.
What does this do to the value of a mutual insurer?
Rather than build up large reserves, most have retained little more than the working capital they require to back the growth of the business. There is usually very little to distribute as a windfall on conversion.
Is this a safe way to run a mutual?
Normally yes, but sometimes they grow so fast that they do not have enough reserves as working capital to back their expansion. These strains sometimes push mutuals into selling out, and analysts say this lies behind the decision by ScotAm to demutualise.
Why was ScotAm offering only pounds 75m to its policyholders to persuade them to relinquish mutual ownership?
You cannot get something for nothing. Since ScotAm's reserves are needed for working capital in the business, there is no surplus to give away to policyholders, as there would be with a building society. So the payment essentially comes from policyholders' own funds, as an advance payment on the proceeds of the flotation ScotAm wants in three to five years' time.
How does the flotation change things?
ScotAm claims it will run the business better - and make it more valuable - with the help of a pounds 350m cash injection to the with-profits fund from Swiss Re.
Only strongly capitalised life funds find it prudent to have a large proportion of equity investments, which generally bring higher returns. With the money, and further help from Swiss Re's partner Securitas, ScotAm hoped to achieve these higher returns and sell more policies. Present policyholders would only gain if the management of the new business did improve profitability dramatically. ScotAm held out the prospect of a pounds 200-pounds 400m further payment on flotation.
But didn't ScotAm say that it aimed to make the company worth pounds 1bn at flotation? If so, where would the rest of the money have gone?
Stock market shareholders in ScotAm Plc - as the company would have become after flotation - would be buying an interest in the new business and in the life funds, as well as repaying Swiss Re's pounds 350m.
However, policyholders do not just have equity and bond investments through their policies. They also own the embedded value in the life fund, which is the current worth of the entire future stream of income it is expected to generate as it grows.
Shareholders in a demutualised life insurer are entitled to take 10 per cent of the future profits, which hitherto had belonged entirely to policyholders. This of course has to be paid for.
Most of the money shareholders would subscribe on flotation would be to compensate policyholders for the loss of part of their future profits from the fund. It fills the hole left by the lost stream of future profits, so there is no surplus to distribute to policyholders.
So why was Abbey National saying it wanted to pay pounds 1.4bn upfront?
In exactly this way, Abbey National is promising to pay around pounds 1bn for the embedded value of the life fund.
However, as an outsider, it can afford to pay an additional pounds 400m premium for goodwill. ScotAm could not do this because it only had policyholders' own funds to play with. Abbey's was a good offer, until Prudential came along.
What is so special about the Pru's offer?
The Pru, headed by Peter Davies, has tried a different tack. It has a large life fund of its own, which can easily absorb the whole of the ScotAm fund.
But if that happens, ScotAm no longer needs to finance a large sales force and all the other paraphernalia required to attract new business. It no longer has any need, therefore, for working capital. By closing down ScotAm to new business in this way, the Pru is able to release pounds 400m for its existing policyholders. The rest of the pounds 1.9bn the Pru is offering comprises a pounds 1.1bn repayable loan and pounds 400m in goodwill.
The most interesting feature of the Pru offer is therefore that it is giving back to ScotAm policyholders their own money, released from the embedded value of their own life fund, which it proposes to close. All future new business will be written from the Pru's own fund.
So where does that leave ScotAm?
At present, there are three offers. Two of them - ScotAm's own and the Pru's - in different degrees pay policyholders a slice of their own money, through the use of clever financial engineering. Abbey National offers cash payment, but then so does the Pru, in addition to its bonus plan. This makes its offer the best.
The bidding war has probably not finished. But remember that the board does not have to sell to the highest bidder, and can take the needs of employees and future policyholders into account in its decision.
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